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Guides, Handbooks and Manuals American Institute of Certified Public Accountants (AICPA) Historical Collection

1956

40 questions and answers about audit reports 40 questions and answers about audit reports

American Institute of Certified Public Accountants (AICPA)

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40 Questions and Answers about

AUDIT REPORTS

answers to questions bankers are likely to ask

about CPA audits and audit programs

AMERICAN INSTITUTE OF ACCOUNTANTS270 Madison Avenue New York 16

INDEPENDENCEExcerpts from Rules of Professional Conduct,

American Institute of Accountants

5. In expressing an opinion on representations in financial state­ments which he has examined, a member may be held guilty of an act discreditable to the profession if

(a) he fails to disclose a material fact known to him which is not disclosed in the financial statements but disclosure of which is neces­sary to make the financial statements not misleading; or

(b) he fails to report any material misstatement known to him to appear in the financial statement; or

(c) he is materially negligent in the conduct of his examination or in making his report thereon; or

(d) he fails to acquire sufficient information to warrant expres­sion of an opinion, or his exceptions are sufficiently material to nega­tive the expression of an opinion; or

(e) he fails to direct attention to any material departure from generally accepted accounting principles or to disclose any material omission of generally accepted auditing procedure applicable in the circumstances.

13. A member shall not express his opinion on financial statements of any enterprise financed in whole or in part by public distribution of securities, if he owns or is committed to acquire a financial interest in the enterprise which is substantial either in relation to its capital or to his own personal fortune, or if a member of his immediate family owns or is committed to acquire a substantial interest in the enterprise. A member shall not express his opinion on financial statements which are used as a basis of credit if he owns or is committed to acquire a finan­cial interest in the enterprise which is substantial either in relation to its capital or to his own personal fortune or if a member of his immedi­ate family owns or is committed to acquire a substantial interest in the enterprise, unless in his report he discloses such interest.

A Brief Note to Bankers

This publication has been prepared by this committee of the American Institute of Accountants with the assistance of the Robert Morris Associates and the American Bankers Association. It is presented in question and answer form for ready reference and has the following objectives:

1. To help explain the auditing standards observed, and some of the auditing procedures that may be employed by certified public accountants in forming an opinion on the presentation of financial position and results of operations in a company’s financial statements.

2. To emphasize the responsibilities assumed by the members of the accounting profession when they ex­press an independent opinion on financial statements.

If these two objectives are achieved by the publication of this booklet, it will promote better understanding and better and stronger ties between the public accounting profession and those responsible for granting credit.

The CPA’s Function

In reaching a decision whether to extend credit, a banker considers many factors. Among the most important of these are the financial position of the borrower and the results of its operations as shown by its financial statements. Bankers rely upon the independent CPA for an opinion as to whether the financial statements present fairly this information.

The banker desires the unqualified opinion of a CPA, ex­pressed in language similar to that contained in the standard short form of report developed by the American Institute of

Accountants and reprinted on page 17 of this booklet. The language of the standard short form of report has been de­veloped to express precisely and concisely the CPA’s repre­sentations as to the examination performed and his conclu­sions as to the financial statements. While these representa­tions could be stated at greater length, added verbiage would not alter the essential character of what is stated.

Perhaps one point should be stressed above all others. The CPA’s opinion, whether unqualified or qualified, is not formed merely by checking figures in the books or other rec­ords. Many questions arise during an examination that re­quire the exercise of mature, experienced judgment. Obvi­ously, the value of a CPA’s opinion rests on the quality of his judgment and his independence. In expressing an opinion, the CPA assumes a heavy responsibility for the professional competence of his work.

The answers given in this booklet cover most of the ques­tions that may reasonably be expected to arise in the use of audit reports issued by certified public accountants.

Committee on Cooperation withBankers and Other Credit GrantorsAmerican Institute of Accountants (1955-1956)

R. Bauhof, Chairman P. J. Adam James E. Burgess Frank S. Calkins Carroll F. Davis Boone Goode Ralph V. Hunt William P. Hutchison

Paul KatzenR. G. RankinJoseph J. Seaman Lawrence J. Seidman Robert Zech

Carman G. BloughDirector of Research

September, 1956

ContentsPage

The CPA’s ReportOpinions

1. Kinds of opinions ......................................................... 52. Unqualified opinion ..................................................... 53. Qualified opinion ......................................................... 64. Disclaimer of opinion ................................................. 75. No statement as to opinion ......................................... 86. CPA’s name on financial statements or report cover 9

Auditing Standards7. As referred to in audit reports ..................................... 98. Independence................................................................. 10

Accounting Principles9. “Present fairly” ............................................................... 11

10. “Generally accepted accounting principles” .............. 1111. Consistent application of accounting principles......... 12

Content of Report12. General purpose report ................................................. 1213. Auditing standards same for short-form and long-form

reports ........................................................................ 1314. Details of scope of examination ................................. 14

The CPA’s ExaminationScope of Examination

15. Determination of scope of examination ..................... 1516. Not a complete verification ......................................... 1517. “Tests” ........................................................................... 16

Internal Control18. Meaning of term ......................................................... 1619. Effect on scope of examination ................................. 21

Page

Receivables20. Procedures to substantiate receivables ..................... 2221. Confirmation of receivables........................................... 23

Inventories22. CPA’s responsibility for correctness .............................. 2323. “Observation” of inventories ...................................... 2424. Stated value of inventories .......................................... 2425. Obsolescence ................................................................... 2526. Purchase commitments ......................................................2527. Client’s representation letter ...................................... 25

Fixed Assets28. Procedures to substantiate fixed assets ..................... 2629. Commitments for acquisition or construction............. 2730. Stated at cost ................................................................. 27

Other Items31. Accounts payable ......................................................... 2732. Accruals for expenses ................................................... 2833. Loan agreements ........................................................... 2834. Contingent liabilities ................................................... 2935. Sales ............................................................................... 2936. Operating accounts ....................................................... 3037. Income taxes ................................................................. 30

Miscellaneous38. Events between date of financial statements and date

of CPA’s report ........................................................ 3239. Prepaid expenses and cash surrender value of life

insurance .................................................................... 3240. CPA’s confidential relationship with client.................. 33

Explanation of Certain Terms.................................... 34

The CPA’s ReportOpinions

1) What kinds of opinions do CPAs express regarding financial statements?

Depending upon his findings, the CPA may express: a) an unqualified opinion as to the over-all fairness of

the presentation of the financial data in conformity with generally accepted accounting principles con­sistently applied; or

b) an opinion qualified as to certain items on the financial statements or as to the consistent applica­tion of accounting principles.

However, he expresses only one kind of opinion on any par­ticular set of financial statements. In some cases he may feel that he cannot give an opinion under the circumstances, in which case he should disclaim an opinion.

2) When does a CPA express an unqualified opinion?

If he is satisfied that the financial statements present fairly the financial position and results of operations in con­formity with generally accepted accounting principles con­sistently applied, the CPA usually expresses an unqualified opinion to that effect.

He should not express an unqualified opinion unless he is satisfied in all material respects and has adequate grounds for his opinion. Bankers can help to assure un­qualified opinions on the basis of adequate examinations by stressing to customers the necessity of receiving audit reports

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on which they can rely. The standard short-form report, re­printed on page 17 of this booklet, is an example of an un­qualified opinion. Any deviation from the standard form should be read very carefully.

On occasion the section of the CPA’s report dealing with the scope of his examination states that he has not, for ex­ample, confirmed accounts receivable, or has not observed the taking of inventories. If the receivables or inventories are material, he should disclaim an opinion except in rare cir­cumstances where he may have been able to satisfy himself as to the items by other procedures, in which case he should say so and express an unqualified opinion. In other words, a qualification as to the scope of the examination does not always mean that the opinion is qualified.

An example of qualified scope of examination language is shown on page 18.

3) When does a CPA express a qualified opinion?

When a CPA believes the statements are a generally fair presentation, but he has not been completely satisfied on some point, or he feels that some part of the financial posi­tion or results of operations is not fairly presented, he may express a qualified opinion and indicate the nature of the reservation or exception. In general, the necessity for ex­pressing a qualified opinion occurs when the CPA has not been permitted or was otherwise unable to make an exami­nation sufficiently complete to warrant the expression of an unqualified opinion, or when he has found departures from accepted accounting principles which the company is un­willing to correct. Where a significant change has been made in the application of accounting principles the CPA quali­fies his opinion as to the consistent application of generally accepted accounting principles. If he approves the change,

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he usually so states. Where possible, the CPA indicates the materiality of certain types of qualifications.

An example of qualified opinion language is shown on page 19.

When the CPA’s exceptions as to accounting practices followed by the client are of such significance that he has reached a definite conclusion that the financial statements do not present fairly the financial position and results of operations, his report should clearly indicate his disagree­ment with the statements presented and give his reasons.

The CPA should not express an over-all opinion on the financial statements when, because of limitations on the scope of his examination or departures in the statements from generally accepted accounting principles, his excep­tions or reservations would be such as to destroy the useful­ness of an opinion on the statements taken as a whole. In such cases, he is not in a position to have formed an opinion as to whether statements make a fair presentation. (See question 4.)

4) When does a CPA disclaim an opinion?

The CPA should not express an opinion that financial statements present fairly financial position and results of operations in conformity with generally accepted accounting principles, when his exceptions are such as to negative the opinion, or when the examination has been less in scope than he considers necessary to express an opinion on the statements taken as a whole. In such circumstances, when­ever the CPA permits his name to be associated with finan­cial statements, he should state that he is not in a position to express an opinion on the statements taken as a whole and should indicate clearly his reasons therefor.

His disclaimer of opinion should be stated in writing

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either in a letter of transmittal bound with the financial statements or in the more conventional short-form or long- form report. However, when financial statements prepared without audit are presented in a CPA’s report cover or on his stationery without comment by the CPA, a warning, such as Prepared from the Books Without Audit, appearing prominently on each page of the financial statements is con­sidered sufficient.

It is not contemplated that the disclaimer of opinion should assume a standardized form. Any expression which clearly states that an opinion has been withheld and gives the reasons why is suitable for this purpose. However, it is not considered sufficient to state merely that certain audit­ing procedures were omitted, or that certain departures from generally accepted accounting principles were noted, without explaining their effect upon the CPA’s opinion re­garding the statements taken as a whole. It is incumbent upon the CPA, not upon the reader of his report, to evalu­ate these matters as they affect the significance of his exami­nation and the fairness of the financial statements.

An example of a disclaimer of opinion is reprinted on page 20 of this booklet.

When the CPA has had to disclaim an opinion on the financial statements, his report is of dubious value to the banker.

5) Is it an approved practice to recite in audit reports the procedures followed without stating clearly wheth­er or not an opinion is expressed?

No. The membership of the American Institute of Accountants in 1949 approved a statement (incorporated in the summary of generally accepted auditing standards as the fourth standard of reporting and often referred to as

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Statement No. 23) which calls upon the accountant either to express an over-all opinion regarding the statements taken as a whole, or to assert that such an opinion cannot be ex­pressed whenever financial statements appear on his sta­tionery or in his report. If no opinion is given, he should state why. (See question 4.)

6) Does a CPA’s name on financial statements, or on the report cover, mean that he approves them?

No. CPAs often perform services for clients that re­quire little or no audit work. Accordingly, he may not have a basis for approving the financial statements, depending upon the services he has been engaged to perform in the par­ticular engagement. The CPA is obliged to disclose in his report the responsibility he assumes for the fairness of finan­cial statements. The banker has an obligation to read the CPA’s report carefully to be sure that the information de­veloped by the engagement is suited to credit purposes.

Auditing Standards

7) What are the “auditing standards” referred to in audit reports?

Auditing standards are the underlying principles of auditing which control the nature and extent of evidence to be obtained by means of auditing procedures. They are broad in scope, and concern both the CPA’s personal quali­fications, and the quality of his work. Whereas auditing procedures must be varied to meet the requirements of the particular engagement, standards to be observed in selecting and applying the procedures are the same in all examina­

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tions. (A summary of generally accepted auditing standards adopted by the membership of the American Institute of Accountants is presented inside the back cover of this booklet.)

The circumstances that exist in each audit engagement require differences to a greater or lesser degree in the audit­ing procedures that should be employed, the manner in which they should be used, and the extent to which they should be applied. These differences make it impossible to lay down a uniform program of procedures which would be generally satisfactory. The program of procedures for any particular engagement is developed through the exercise of the, experienced judgment of the CPA. This philosophy is summed up in the standard audit report in the words: “Our examination . . . included such tests of the accounting rec­ords and such other auditing procedures as we considered necessary in the circumstances.”

8) What is the significance of “independence” in relation to audit work?

The term “independent accountant” means what the words imply. Independence is the keystone of the accounting profession. It is one of the CPA’s most important attributes. If a CPA abides by the Rules of Professional Conduct of the American Institute of Accountants, and similar rules adopt­ed by numerous state societies of certified public accountants, he obviously must be independent in his relationship to clients.

While none of the Rules of Professional Conduct of the American Institute of Accountants deal solely with indepen­dence, those which should be of particular interest to bankers in this respect are reprinted inside the front cover of this booklet.

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Accounting Principles

9) What is the significance of the expression “present fairly" in the CPA's report?

The values of many items in financial statements can­not be measured exactly. The items which, in part at least, are subject to approximation are among the most important in the financial statements, such as inventories and provisions for current costs expected to be paid in the future.

Because of this, no one can be in a position to state that a company’s financial statements “exactly present” financial position or results of operations. Accordingly, the CPA usu­ally states that the financial statements “present fairly” in the sense that he believes they are substantially correct. For the same reason, his findings are expressed in the form of an opinion. However, it should be borne in mind that the judg­ment involved is an informed one, and is guided by generally accepted accounting principles.

10) What are “generally accepted accounting principles33?

They are a body of conventions for dealing with ac­counting problems. They have been developed over the years as a result of study and experience in presenting useful finan­cial information, and have come to be widely recognized as sound guides in making accounting decisions. When financial statements have been prepared in conformity with generally accepted accounting principles, they should reflect financial facts fairly, even though approximations and estimates have been necessary. The series of Accounting Research Bulletins issued by the committee on accounting procedure of the American Institute of Accountants are expressions of gener­ally accepted accounting principles with respect to the matters covered by the bulletins.

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11) What does the CPA do to determine consistency in the application of accounting principles?

The audit work for the period under examination pro­vides the basis for his opinion as to that period. If an ex­amination was made in the prior period that, of course, also provides the basis for the CPA’s opinion as to the prior period. If no examination was made in the prior period, the CPA makes whatever review of prior periods he feels is necessary to satisfy himself as to the consistency of applica­tion of accounting principles.

Content of Report

12) Are CPA audit reports prepared specifically for credit purposes?

No. Most audit reports are prepared for “general” purposes; that is, they are intended to be useful to manage­ment, and stockholders and others, as well as to creditors. However, if it is known that the report will be used for credit purposes, and if the credit grantor makes known to his customer the information he wants, the customer can usually arrange to have the CPA present the desired information. (A booklet prepared by the Robert Morris Associates, the national association of bank loan officers and credit men, entitled Financial Statements for Bank Credit Purposes, de­scribes financial information generally required by bankers. Copies may be obtained from Robert Morris Associates, Philadelphia National Bank Building, Broad and Chestnut Streets, Philadelphia, Pennsylvania, at 10 cents each.)

Some matters observed during the course of the examina­tion are considered to be important primarily for internal consideration and are generally excluded from reports pre­

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pared for general purposes. For example, CPAs often pre­pare separate memoranda for management which contain suggestions for improving internal control, accounting pro­cedures, method of operations, etc.

13) Are the auditing standards for a short-form report any different than those for a long-form report?

No. The auditing standards to be observed by a CPA, and the examination, are the same regardless of whether he prepares a short-form or a long-form report. The only im­portant difference between the two kinds of reports is that the long-form report includes more details and comments regarding the financial position and results of operations. Language similar to that used in the standard short-form report (reprinted on page 17 of this booklet) should be in­corporated in the long-form report.

Frequently, the client does not need a report presenting details and comments regarding financial position and re­sults of operations, and is unwilling to pay the cost involved in preparing one for his own purposes. However, bankers find information as to such details useful. If they consider it important to have it included in the report, they should take the initiative by requesting the customer to authorize the CPA to prepare it. They should recognize, however, that there are data regarding which the CPA is willing to supply the best information available but as to which it is not prac­ticable or reasonable for him to express an opinion. Exam­ples are unit sales, production figures, or monthly balances of payables (which the ordinary audit would not cover in sufficient detail to support a regular type of opinion), and budget forecasts and adequacy of insurance coverage (which by their nature are not susceptible to audit check).

The CPA’s opinion runs generally to the basic financial

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statements, with a lesser degree of responsibility being as­sumed with respect to the other financial data included in the long-form report. Information included in the CPA’s comments and financial data other than the basic financial statements in the long-form report should not be construed as being necessary to the fair presentation and understand­ing of the basic financial statements in the report.

14) Why don't more reports present details as to the scope of the examination?

Although some long-form reports comment in consid­erable detail on auditing procedures employed, most CPA’s believe that such comments are of no real use to bankers, and therefore omit them. One reason for this is that it is not prac­ticable to describe fully in a report the program followed and the considerations involved. However, of even greater importance is the fact that no one can judge solely from a description of audit procedures whether an examination was adequate in the circumstances unless he is familiar with all of the facts in the particular case and with developments during the examination as it progressed. Conclusions as to the adequacy of an examination are not likely to be well founded if based merely on the information that could be presented in a report.

When a CPA states that his examination was made in accordance with generally accepted auditing standards, he takes responsibility for having made an adequate examina­tion. Accordingly, bankers are justified in placing the same reliance upon a short-form report which contains that state­ment as they do upon a long-form report.

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The CPA’s ExaminationScope of Examination

15) Does the CPA have a free hand in deciding upon the scope of his examination?

The CPA determines the scope of the examination necessary to express an unqualified opinion. The client, how­ever, determines whether an examination of such a scope will be permitted. It is the CPA’s opinion that must be ex­pressed. He assumes the responsibility and he must be per­mitted to perform all of the procedures he considers neces­sary if the objective is an unqualified opinion.

There may be reasons why a client decides not to permit an unrestricted examination. While the CPA abides by his client’s decision, he patterns his report accordingly. The significance of this to bankers is that they should read the report to be sure that the opinion expressed is adequate for their purposes. To be sure that an acceptable opinion is ob­tained, they should, before the work is begun, see that the CPA is authorized by his client to perform an examination of sufficient scope to provide a suitable opinion.

16) Is an examination an exact arid complete verification of the figures on the statements?

No. In most examinations, investigation of every trans­action would not only be excessively costly—it is also un­necessary. The CPA bases his examination upon tests of the records, and upon investigation of selected transactions. He makes an examination which in his opinion is sufficient to satisfy him that the financial information is fairly presented in all material respects.

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17) What does the CPA mean by “tests”?

“Sampling” may also be descriptive of the word “tests” frequently used by CPAs. When the CPA states that his ex­amination has “included such tests of the accounting rec­ords” as he considered necessary in the circumstances, he means that he has examined a portion of the transactions and records to the extent he believes necessary for the ex­pression of an opinion in a particular situation.

The extent of testing in any examination is decided by the CPA on the basis of his best judgment as to the amount required to constitute a fair sampling of the record being tested in the particular case. In deciding upon the character of the tests to be made, and the extent to which they should be applied, one of the most important factors taken into con­sideration is the effectiveness of the company’s system of internal control. Other factors which enter into the decision include the materiality of the item to be tested, and the relative risk of the existence of irregularities.

A statement, fact, or item is material, if in the surround­ing circumstances as they exist at the time, it is of such a nature that its disclosure or the method of treating it would be likely to influence or to “make a difference” in the judg­ment and conduct of a reasonable person. In applying his auditing procedures, the CPA focuses principal attention upon items which are, or may be, material.

Internal Control

18) What does the term “internal control” mean?

Internal control comprises the plan of organization and all of the coordinate methods and measures adopted within a business to safeguard its assets, check the accuracy

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Unqualified Opinion (Standard Short-Form of Accountant's Report)

We have examined the balance sheet of X Company as of December 31, 195x and the related statements of income and retained earnings for the year then ended. Our examination was made in accordance with generally accepted auditing standards, and accordingly included such tests of the ac­counting records and such other auditing procedures as we considered necessary in the circumstances.

In our opinion, the accompanying balance sheet and statements of income and retained earnings present fairly the financial position of X Company at December 31, 195x, and the results of its operations for the year then ended, in con­formity with generally accepted accounting principles ap­plied on a basis consistent with that of the preceding year.

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Qualification as to Scope-Unqualified Opinion

... Our examination was made in accordance with gener­ally accepted auditing standards, and accordingly included such tests of the accounting records and such other auditing procedures as we considered necessary in the circumstances; however, it was not practicable to confirm accounts receiv­able from government agencies, as to which we have satisfied ourselves by other auditing procedures.

In our opinion, the accompanying balance sheet and state­ments of income and retained earnings present fairly . . .

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Qualified Opinion

... Our examination was made in accordance with gener­ally accepted auditing standards, and accordingly included such tests of the accounting records and such other auditing procedures as we considered necessary in the circumstances.

In our opinion, except as to such adjustments as may re­sult from final determination of litigation as explained in Note 1, the accompanying balance sheet and statements of income and retained earnings present fairly . . .

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Disclaimer of Opinion

In accordance with the terms of our engagement, we did not follow the generally accepted auditing procedures of communicating with debtors to confirm accounts receivable balances and of observing the methods used by your em­ployees in determining inventory quantities. Because of these limitations, the scope of our examination was not sufficient to permit us to express an opinion on the accompanying financial statements taken as a whole.

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and reliability of its accounting data, promote operational efficiency, and encourage adherence to prescribed mana­gerial policies. From the viewpoint of the CPA’s examina­tion, it means primarily the measures adopted by the busi­ness to check the reliability and accuracy of its accounting data.

The degree of internal control varies greatly among com­panies. For example, most large companies have well devel­oped and effective systems of internal control and internal auditing procedures; while many small companies, because of few employees or failure to recognize the value of internal control, have less effective systems.

The primary responsibility for the establishment and en­forcement of internal control rests with the company. The ordinary examination incident to the issuance of an opinion respecting financial statements is not designed and cannot be relied upon to disclose defalcations and similar irregulari­ties, although their discovery frequently results. If a CPA were to attempt to discover defalcations and similar irregu­larities, he would have to extend his work to a point where its cost would be prohibitive. It is generally recognized that good internal control and surety bonds provide effective measures of protection.

19) To what extent does the scope of an examination depend upon the effectiveness of the system of internal control?

While the primary responsibility for adequate internal control rests with the client, its effectiveness is of vital im­portance in the selection and application of appropriate audit procedures. When evidence exists that the system is effective, the CPA properly concludes that the accounting records and supporting data have a higher degree of de­

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pendability than would otherwise be the case, and limits his testing accordingly. However, when his investigation shows that the system has points of weakness, he extends the scope of his testing. If the internal control is considered grossly ineffective, the CPA is compelled to extend his procedures considerably before expressing an informed opinion on the financial statements.

Receivables

20) What does the CPA do to substantiate the amounts of accounts and notes receivable reported?

The principal purposes of the CPA’s examination of receivables are to establish their genuineness, the proper re­cording of receipts and the correctness of the balances, and to test the internal control. In addition, the CPA takes steps, such as analyzing the accounts according to age, to satisfy himself that reasonable allowances have been made for probable losses on doubtful accounts.

Accepted practice requires the CPA to seek confirmation of a representative portion of the balances of receivables wherever practicable and reasonable, and where the aggre­gate amount of the receivables represents a significant por­tion of the current assets or the total assets of the company. The method, the extent, and the time of confirming receiv­ables in each engagement, and whether all receivables, or a part of them, should be confirmed, are determined by the CPA in the light of the particular circumstances.

Although experience has demonstrated that confirmation is generally the most important procedure in substantiating receivables, it does not provide conclusive evidence. The CPA employs numerous additional procedures to satisfy himself as to the receivables, such as the inspection of subse­

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quent collections, and making sure that the details on the trial balances are in agreement with the balances in the in­dividual accounts, and that the totals are in agreement with the general ledger. The accounts may, at the same time, be scrutinized for unusually large items or for items which for other reasons appear to require special investigation.

The CPA also looks for the pledge, assignment or other hypothecation of receivables and customarily inspects the instruments in support of notes receivable.

21) What is meant by “confirmation of receivables”?

Confirmation consists of direct communication with the debtor to determine whether or not the balance shown on the company’s books is in agreement with the debtor’s records. Confirmation of the receivables is frequently per­formed on a test basis. If receivables have not been con­firmed, and they are material, the CPA should state that fact in his report and indicate whether or not he has satisfied himself by other auditing procedures.

Inventories

22) What responsibility does the CPA assume for the correctness of inventories?

The CPA’s procedures are designed to satisfy him that the amounts set forth by the company as inventories repre­sent actual inventories either on or off the client’s premises, that they are presented with reasonable accuracy and in accordance with generally accepted accounting principles consistently applied, and that the bases of stating the inven­tories as well as any pledge or assignment of inventories, are properly disclosed. These objectives require the CPA to in­

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vestigate the care and accuracy with which the company has taken the inventories, the methods and bases adopted by the company in pricing them, and the substantial correctness of the company’s mathematical computations. The CPA does not hold himself out as an appraiser, valuer, or expert in materials. He does not “take,” “determine,” or “supervise” the inventory.

23) What is “observation of inventories”?

To satisfy himself that the taking of the inventories was done carefully and accurately, and also to gain general familiarity with them, the CPA is required by generally ac­cepted auditing practice to be present at the inventory tak­ing to observe the effectiveness of the procedures when it is practicable and reasonable to do so and the amount of the inventories is significant. Although the CPA may review and approve the instructions for taking the inventories and may test some items, it is the company’s responsibility to take the inventory satisfactorily. The CPA’s purpose in observing the inventory taking is to satisfy himself that the company is discharging its responsibility.

24) What does the CPA do to satisfy himself as to the fairness of the value at which inventories are stated?

It is the CPA’s duty to make sufficient tests to satisfy himself that the method, or combination of methods, used to determine “cost” and “market” is being applied properly and consistently. To do this, it is generally necessary to make rather extensive tests of the inventory records. These tests may include comparisons of items as shown by the inventory taking with quantities shown on the records, inspection of

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purchase invoices, investigation of current market quota­tions, and verification of footings and extensions. They may also involve a general examination of the company’s cost system, including a review of the allocation of overhead, as a check upon the pricing or valuing of inventories of work in process and finished goods.

25) What does the CPA do about determining the extent of obsolescence of inventories?

Throughout the inventory examination the CPA is on the alert to detect obsolete and slow-moving stock and to ascertain that adequate provision has been made to cover any probable substantial losses thereon.

26) What does the CPA do as to inventory purchase commitments?

The CPA’s primary objective with respect to purchase commitments is to satisfy himself that adequate provision has been made for indicated probable losses. Evidence of such commitments may be disclosed during almost any phase of the examination, and the CPA investigates any leads obtained. He also makes general inquiry among those who would be in a position to have knowledge of such commit­ments, and often obtains a letter of representation from the management to the effect that adequate provision has been made for all expected losses.

27) Why are officers of the client asked to sign representa­tion letters regarding inventories and other matters?

This is a customary procedure based on management’s primary accountability for the company’s financial state­

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ments. These certificates merely supplement the CPA’s work on the examination but do not relieve him from responsi­bility for his opinion with respect to the financial statements.

Fixed Assets

28) What does the CPA do to substantiate the amount reported for property, plant and equipment?

In examining these accounts the CPA’s work consists largely of a review of the accounting principles applied by the company, analysis of the property accounts, and tests of the supporting data.

His review of the accounting principles applied is direct­ed to the company’s accounting practices with respect to depreciation, betterments, additions, retirements, repairs and replacements, to determine that these practices are in accordance with generally accepted accounting principles and have been consistently applied.

In his analysis of the accounts, the CPA customarily pays particular attention to the changes during the period under review, relying to a large extent upon inspection of support­ing documents, such as authorization by the board of direc­tors, work orders, invoices, and journal entries, in assuring himself that these changes had been properly recorded.

If the company leases its premises, the CPA generally ex­amines the leases, noting their terms, and reviews the com­pany’s records to satisfy himself that any leasehold improve­ments are being properly written off, and that significant information regarding any long-term lease arrangements is adequately disclosed.

The CPA’s review of the company’s depreciation policies is generally made in conjunction with his examination of the property accounts. It is the CPA’s responsibility to satisfy

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himself that the method adopted by the company is an accepted method and that it has been properly applied. This conforms to the general concept that the financial statements are statements of the client, and that the CPA’s function is to examine the statements.

29) What is the CPA’s responsibility with respect to com­mitments for the acquisition or construction of major capital additions?

The CPA has the responsibility to make inquiry as to the existence of significant commitments for the acquisition or construction of major capital items. These should be ap­propriately reflected by footnote to the financial statements. The CPA should ascertain that such disclosures are in ac­cordance with the agreements and other evidences of the contemplated transactions.

30) Why are fixed assets stated at cost?

The primary reason for using cost is that financial statements are usually prepared on the basis of reporting on stewardship; i.e., the concept that the management is re­porting on how it has utilized the resources made available to it. The net amount at which fixed assets are shown on a financial statement does not necessarily have any direct relationship to their market value or their replacement cost.

Other Items31) What does the CPA do to determine that accounts

payable are properly reported?

The examination of accounts payable is designed to establish, so far as possible, that all are included in the

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financial statements. In addition to checking open items in the accounting records, CPAs during the course of their examination customarily inspect vouchers and payments en­tered in the records subsequent to the balance-sheet date, unpaid invoices not yet entered, and regular monthly state­ments from creditors.

Large accounts which do not represent recent items and accounts which have been active during the period but show no balance at the date of the examination, are generally investigated. Confirmation of such accounts is occasionally requested from the creditors by correspondence, especially when the internal control is weak.

32) What does the CPA do to determine the adequacy of accruals for expenses?

The CPA examines evidence supporting accruals for such liabilities as interest, taxes, salaries and wages, commis­sions, legal expenses and damages, obtaining confirmation where appropriate, and makes whatever computations are necessary to be satisfied that proper accruals of the liabil­ities for these items at the end of the period have been made.

33) What does the CPA do to ascertain that the provisions of loan agreements have been carried out?

The CPA should review loan and similar agreements to satisfy himself that the financial requirements of the agreements, such as working capital, surplus, and dividend restrictions, are being observed. The significant terms of the agreements, together with any defaults in the principal, interest, or sinking fund provisions, or other financial re­quirements, should be disclosed and the amounts involved stated.

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34) What does a CPA do to determine the amount and nature of contingent liabilities, if any?

To satisfy himself that all significant contingent liabil­ities have been given appropriate recognition in the financial statements, the CPA customarily investigates or inquires of the most authoritative sources available for such informa­tion—including revenue agents’ reports, the company’s legal counsel, the banks with which the company does business, and minutes of the meetings of directors and stockholders. He usually obtains from the management of the company a representation letter enumerating all significant items of this nature, and stating that adequate provision has been made in the statements or the pertinent information dis­closed.

Although the dollar amount of litigation is often disclosed in footnotes to the financial statements, there frequently is no way of estimating, even within reasonable limits, the amount at which pending litigation will eventually be settled. Accordingly, it may not be possible to assign a reasonable dollar amount to the litigation in the accounts, although the existence of any significant litigation should al­ways be disclosed. The CPA usually relies upon the opinion of the company’s legal counsel in deciding what recognition, if any, should be given to pending litigation in the financial statements.

35) What does the CPA do to determine material omission or inflation of sales?

Since sales are so closely related to other items in the accounts, particularly inventories, accounts receivable and cash, he relies very largely on his examination of these accounts in satisfying himself as to reliability of the sales

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figures. Procedures directed specifically to satisfying himself that material amounts of sales have not been omitted, or that they have not been inflated, include checks on the cut-off procedures as to purchases and sales at the end of the accounting period and gross profits tests. The latter in­dicates whether or not gross profits for the period compare with experience in prior periods; the reasons for any material variations should be determined.

36) Does the CPA review the operating accounts of a business?

Yes, if he is to express an opinion on the financial state­ments. Much of his review of the operating accounts is per­formed in connection with his work on related assets and liabilities in the balance sheet. As to the operating accounts as such, the CPA depends primarily upon the results of care­ful review, tests, and analyses of the accounts with respect to items recorded during the period and upon comparison with previous periods. He usually tests the more material or extraordinary items by reference to such supporting evi­dence as payrolls, vouchers, journal entries, statistical data prepared by the company, copies of various kinds of agree­ments, budgets, and provisions of corporate minutes.

37) What responsibility does the CPA assume with regard to the income tax provision?

So far as the financial statements are concerned, the CPA’s principal function with respect to income taxes is to satisfy himself that the provision is reasonable. Often, he assists in preparing the tax return and this provides an excel­lent basis for his decision. If he does not prepare the return himself, he usually reviews it. He also ascertains the last date

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to which the tax returns have been examined by government representatives and determines whether or not there are any items in dispute the tax effects of which should be reflected in the financial statements.

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Miscellaneous38) What is the CPA's responsibility as to events occurring

between the date of the financial statements and the date of his report?

Events or transactions sometimes occur subsequent to the balance-sheet date and before the date of the CPA’s report, which may be either extraordinary in character or of unusual importance. They may, therefore, have a material effect on the financial statements or be important in consid­ering the statements.

The CPA has no duty to extend his audit procedures to events or transactions of a subsequent period as such. How­ever, it is well recognized that an effective audit program relating to the period under examination should include certain procedures which are designed to acquaint the CPA with those post-balance-sheet events or transactions as to which he can be chargeable with a duty to have knowl­edge. If any such matters come to his attention, the CPA may request adjustment or annotation of the statements, or make disclosure in his report.

39) Why are prepaid expenses included in current assets and cash surrender value of life insurance policies excluded?

For accounting purposes the term current assets is used to designate cash and other assets or resources which are reasonably expected to be realized in cash, or sold or con­sumed during the normal operating cycle of the business. Prepaid expenses such as insurance, interest, rents, taxes, unused royalties, and current paid advertising service not yet received, are considered current assets under this defini­

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tion. They are not current in the sense that they will be converted into cash, but in the sense that, if not paid in advance, they would require the use of current assets during the operating cycle.

The accounting concept of the nature of current assets excludes cash surrender value of life insurance policies from the current classification because, as a practical matter, life insurance policies are more in the nature of long-term in­vestments which in the ordinary course of business do not provide working funds.

40) Is the CPA free to discuss his client’s affairs with bankers?

The CPA’s relationship with his client is a confiden­tial one similar to that which a banker has with his customer. However, the CPA will be glad to discuss his client’s affairs with bankers if authorized to do so by the client. It is often desirable for the client, the banker, and the CPA to meet together.

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Explanation of Certain TermsThere are a number of terms used in this booklet which

deserve special mention, either because they have technical meanings that differ somewhat from their meanings in every­day usage or because the concept they express requires a more complete explanation than seems appropriate in a series of brief questions and answers. The more important of these are explained here.Analysis and Review: The principal means by which the CPA carries out his audit procedures is through careful analysis and critical review of the data presented, with a view to appraising whether they appear to be reasonable and reliable, rather than through a detailed checking of transactions.Auditing Standards: The underlying principles of auditing which govern the nature and extent of the evidence to be obtained by means of auditing procedures, and which relate to the CPA’s personal qualifications and the quality of his work, are referred to as generally accepted auditing stand­ards. A summary of these standards appears inside the back cover of this booklet.Confirmation: In numerous phases of the examination, the CPA seeks information as to items shown on the records by direct communication with the individual or company in a position to verify such items. This is commonly referred to as “confirmation,” and is particularly valuable because the CPA communicates directly with persons or organiza­tions that are independent of the company under examina­tion.

Disclaimer of Opinion: A statement to the effect that the CPA is not in a position to express an opinion on the fair­ness of the financial presentation.

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Examination (Audit): The process through which the CPA reaches an opinion as to the fairness of financial statements, including:

a) A review and evaluation of the existing internal con­trol ;

b) A general review of the accounts and records, and comparison of the figures shown on the statements with the sources from which they were drawn;

c) A study of the accounting procedures regularly fol­lowed by the company, and consideration of any de­partures from these practices;

d) Independent sampling tests (through inspection, cor­respondence, or other means) of the existence of assets;

e) Tests to determine so far as reasonably possible, that all liabilities are reflected in the balance sheet;

f) Analyses, tests, and over-all review of the income and expense accounts;

g) Test procedures designed to determine the credibility and general correctness of the accounts on which the statements are based; and

h) Inquiries of officers, employees and others to supple­ment the information otherwised developed by the examination.

Inspection: The CPA’s work involves the inspection of some physical assets, and of documents and other evidence sup­porting the figures in the accounting records. This process includes such procedures as counting cash on hand and securities, examining notes, leases, etc., testing the inventory taking, and visiting plants to gain general familiarity with the company’s facilities and operations. It also includes such steps as examining invoices, checks, and other documents supporting entries in the books, and reading the minutes of stockholders’ and directors’ meetings for information on actions authorized by those groups.

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Internal Control, System of: Internal control is a big subject about which it is difficult to generalize. However, a satis­factory system of internal control would certainly include:

a) Appropriate segregation of functional responsibilities;b) Adequate authorizing and recording procedures to

provide reasonable accounting control of assets, lia­bilities, revenues and expenses;

c) Sound practices in the performance of duties and functions of each of the organizational departments; and

d) A degree of quality of personnel commensurate with responsibilities.

Observation: The term “observation,” as used in examina­tions, refers to the practice of being present to observe the manner in which various procedures of the company are being performed by its employees. In particular, it is used in reference to the CPA’s attendance at the taking of the inventory. In the course of his examination, the CPA should also observe the company’s procedures in the handling of cash, and in the operation of other phases of its system of internal control.Opinion: The CPA’s statement as to his conclusions regard­ing the fairness of the financial presentation.

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SUMMARY OFGENERALLY ACCEPTED AUDITING STANDARDSGeneral Standards

1. The examination is to be performed by a person or persons hav­ing adequate technical training and proficiency as an auditor.

2. In all matters relating to the assignment an independence in mental attitude is to be maintained by the auditor or auditors.

3. Due professional care is to be exercised in the performance of the examination and the preparation of the report.

Standards of Field Work1. The work is to be adequately planned and assistants, if any, are

to be properly supervised.2. There is to be a proper study and evaluation of the existing inter­

nal control as a basis for reliance thereon and for the determination of the resultant extent of the tests to which auditing procedures are to be restricted.

3. Sufficient competent evidential matter is to be obtained through inspection, observation, inquiries and confirmations to afford a reason­able basis for an opinion regarding the financial statements under ex­amination.

Standards of Reporting1. The report shall state whether the financial statements are pre­

sented in accordance with generally accepted principles of accounting.2. The report shall state whether such principles have been consis­

tently observed in the current period in relation to the preceding period.3. Informative disclosures in the financial statements are to be re­

garded as reasonably adequate unless otherwise stated in the report.4. The report shall either contain an expression of opinion regard­

ing the financial statements, taken as a whole, or an assertion to the effect that an opinion cannot be expressed. When an over-all opinion cannot be expressed, the reasons therefor should be stated. In all cases where an auditor’s name is associated with financial statements the re­port should contain a clear-cut indication of the character of the audi­tor’s examination, if any, and the degree of responsibility he is taking.